Going all the way back to Schumpeter (1934), economists have long discussed whether market competition stimulates innovation. To reconcile conflicting earlier empirical evidence, Aghion and Griffith (2005) developed a model showing that competition can have both a positive and a negative effect on innovation, depending on the degree of competition in the market. Following Aghion and Griffith's work, this paper empirically examines the effect of market competition - measured either by the Herfindahl Index or the Lerner Index - on productivity growth and R&D intensity using micro data for Japan's manufacturing sector. We found evidence of an inverted U-shaped relationship between competition and innovation when we use the Herfindahl Index as a measure of competition in the market. Especially for the period since 2000, the data lend strong support for the hypothesis of an inverted U-shaped curve. In addition, we examined the effect of new entrants on the innovative activity of incumbents. The results of our estimation using a regulation index as our measure of entry barriers suggest that the effect on incumbents' TFP growth depends on their technology level. When incumbents' technology level is close to the technology frontier in their industry, competition from new entrants induces these firms to make efforts to increase their productivity in order to escape from competition. On the other hand, such competition discourages innovation in firms far from the industrial technology frontier.

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